William Martin is the longest-serving Federal Reserve chief, having served from 1952 when Harry Truman was president to 1970. A few years into the role, Truman saw Martin on a New York street. The president from 1945 to 1953 stared at Martin, called him a โtraitorโ and walked away. Martinโs betrayal? He prioritised a successful fight against inflation running at an annualised 21% in 1951, rather than help Truman fund the Korean war by ensuring Washington could borrow at 2.5% or less.
Lyndon Johnson, the fourth of Martinโs five presidents, got frustrated with him too. Johnson enacted fiscal stimulus in 1964 only to see the Fed resist his bullying to keep interest rates low. In 1965, Johnson summoned Martin to his Texas ranch where the president โshoved him around his living room, yelling in his face: โBoys are dying in Vietnam and Bill Martin doesnโt care.โโ When Martinโs final term ended, inflation was 6% and heading to double-digits.
Now President Donald Trump is treating the Fed with similar disrespect. Trump has publicly criticised the โgoing locoโ Fed led by โcluelessโ โenemyโ Jerome Powell about 50 times since mid-2018 over high interest rates and nominated supporters of questionable fit for the Fedโs policy-making board, amid reports he considered sacking his appointee to lead the central bank.
The worry is that Trump is just another menace to the practice whereby central banks set monetary policy to meet inflation and other targets supposedly free of political pressure. Bloomberg counts that 17 central banks faced political interference in 2018. The number includes the European Central Bank that was attacked for radical remedies such as negative rates and for buying government bonds. The Bank of England featured for issuing forecasts unflattering to UKโs future outside the EU โ one Conservative MP in 2019 called Governor Mark Carney a โsecond-tier Canadian politicianโ engaged in โProject Hysteriaโ. Conflicts last year between the Reserve Bank of India and the government led to the governorโs resignation. This year, the head of the Central Bank of the Republic of Turkey was sacked over policy disputes.
Many forces are combining to weaken the autonomy of central banks. Populists are targeting central banks because the global financial crisis discredited the neoliberal framework of which their independence is a part. Central banks have been given more tasks, often bank supervision, that come with controversies. Central bankers are commenting on politically sensitive topics such as climate change and gender quotas. Critics claim their asset-buying programs have boosted inequality by inflating asset prices (even when conceding such tactics staved off recessions).
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But two other reasons stand out that point to the trend intensifying because they relate to the merits of independent monetary policy as a way to manage economies. The first is the raison d’รชtre for independent central banking is waning; low inflation means politicians have lost their incentive to outsource the blame for higher interest rates. The second is that orthodox monetary policies are exhausted and people realise monetary tools canโt be radicalised much more because they promote risks; namely, they inflate asset prices, hinder lending and squeeze bank profits (which increases the risk of financial instability). To overcome this failure of monetary policy to fire sustainable growth, policymakers are pondering fiscal solutions that would dilute the autonomy of central banks.
Japanโs experience shows how political and economic conditions can force action that curtails central-bank freedom. Many argue the Bank of Japan lost its autonomy in 2013 when it became part of Prime Minister Shinzล Abeโs drive to refloat Japanโs deflation-ridden economy. A central feature of โAbenomicsโ is it blurs the distinction between monetary and fiscal policies, which were separated to stop the inflation-prone practice whereby central banks bought government bonds directly from Treasuries to fund fiscal deficits.
As Japanโs fight against deflation shows, the weakening of central-bank autonomy can be an appropriate policy response. But the loss of central-bank autonomy could come at a cost, especially if itโs judged to be due to political pressure rather than economic circumstances. The policy to convince investors and the public that central banks were above the political fray reduced the level of uncertainty in asset prices and instilled public faith that inflation would stay tame, fiat currencies would hold their worth and central banks would act for the common good. If central-bank autonomy were to erode, such investor and public confidence could be hard to restore.
To be sure, most central banks only enjoy a โquasi independenceโ โ some analysts even call central-bank independence a โmythโ, however, John Howard might have disagreed when the Reserve Bank of Australia raised rates during the formal campaign of the 2007 election his government lost. Central banks are entwined in politics because they form part of the executive and they often cooperate with Treasuries, as happened in the US during the global financial crisis. Lawmakers set goals for central banks that can be revised any time. They make central bankers report to parliaments. Many central-bank leaders need to maintain public and parliamentary support to ensure their reappointment. The record of โapoliticalโ central banking has blemishes. The biggest are the global financial crisis and the ECBโs rate increases of 2010 that intensified the eurozone debt crisis.
Whatever their errors or the degree of autonomy, granting central banks independence was an apt political and policy solution when inflation was a threat. Todayโs low-inflation, low-growth and high-debt world will likely call on fiscal remedies that erode central-bank autonomy. The faster central banks exhaust their orthodox options, the sooner comes the day when investor and public faith in these solutions is tested.
Genuine or quasi
German Chancellor Helmut Kohl (1982-1998) wanted a single currency for Europe as his legacy but knew Germans preferred to keep the Deutsche mark. Kohlโs solution was twofold. He created rules around fiscal deficits to assure Germans they would never need to bail out other euro countries. The other was to ensure the ECB be set up without any political oversight to ensure independence to meet its sole goal to control inflation.
The ECBโs treaty-protected independence harked to the establishment of the Bundesbank in 1957 as the worldโs first independent central bank as required by Germanyโs constitution of 1949. The Bundesbankโs freedom to safeguard price stability become more overt after Bretton Woods collapsed in 1973 and fiat currencies were floated. Essentially, political and policy imperatives drove these developments; namely, to guarantee Germans would never again suffer the hyperinflation of the early 1920s and straight after World War II.
The Fedโs shift to a de facto independence is another outcome of political and economic circumstances. The watershed was the Treasury-Federal Accord of 1951, which ended the role the Fed undertook at the start of World War II to buy government bonds to ensure Washington could borrow cheaply. The Fed emerged from Treasury servitude because the central bank needed to fight the price increases caused by its financing of Washingtonโs spending on the Korea war. Inflation soared at the time due to the absence of the price controls used in World War II.
The next notable step to quasi autonomy was when the double-digit inflation of the 1970s prompted Congress to pass the Federal Reserve Reform Act of 1977, which tasked the Fed with the goals of price stability, full employment and moderate interest rates. (The last goal, a subjective one, is overlooked and the law is known as the โdual mandateโ.)
In 1979, Paul Volcker at the start of his eight-year stint as Fed chief used this law to convince the administration of Jimmy Carter that the Fed needed to haul in inflation running at an annualised 11% to ensure full employment over the longer term.
Volcker crushed inflation โ though at the cost of the 1981-1982 recession โ and his triumph inspired other countries to grant their central banks โautonomyโ to control price increases. New Zealand in 1989 became the first country to do so. Canada followed in 1991. Australia, where Paul Keating boasted in 1989 that the RBA was โin his pocketโ, did likewise in 1996. The UK followed in 1997 and Japan in 1998.
But now this quasi independence could fray as policymakers confront a low-inflation, even deflationary, world where growth is challenged, debt is high, trade barriers are rising and asset prices are at record highs.
On July 23, the day Boris Johnson became the new leader of the Conservative party, Andy Haldane, the Bank of Englandโs chief economist, had a warning for the new prime minister. The government canโt expect the โmonetary cavalryโ to rescue the economy, Haldane said. โA decade ago … monetary policy was the right prescription. The game has changed. The right medical prescription (now) is fiscal and structural policies.โ
As policymakers turn to fiscal policy and executive fiat to promote sustainable more-equitable growth, central bankers might morph into public servants whom Truman would consider loyal and to whom Johnson would be friendly. But investors and the public might trust them less, especially if the loss of autonomy occurs while Trump is tweeting against the Fed.
By Michael Collins, Investment Specialist, Magellan Group